Exploring cryptoasset regulation

Since then, the cryptoassets market has continued to grow. According to a report from the Bank of Canada (BoC), the global market capitalization for cryptoassets “grew rapidly” in 2017 and the daily transaction volume now is more than 75 times higher than it was in early 2017 – i.e., more than $25 billion a day.

At this point, the BoC report states, traditional financial services institutions don’t have much, if any, direct exposure to cryptoassets, but the report cautions that these institutions could become exposed due to their clients’ trading in cryptoassets or through exchange trading in crypto-based derivatives.

“Cryptoasset markets are evolving quickly and could have financial stability implications in the future if their size and links to the financial system continue to grow,” the BoC report states. “The markets are largely unregulated in many countries and are characterized by high price volatility, fragile liquidity, and frequent fraud and cyberattacks.”

The Senate committee’s original report in 2015 acknowledged risks, such as money laundering and tax evasion, that could accompany widespread use of cryptocurrencies. The report also recognized that a heavy-handed approach to regulation could stifle innovation and lead to missed opportunities – opportunities resulting from the development of the underlying financial technology that enables the creation of cryptocurrencies (via blockchain [a.k.a. distributed ledger] technology) and improves inclusion and enhances the efficiency and security of cryptocurrencies in financial transactions.

Now, as the cryptoassets market continues to flourish, the Senate committee is revisiting the subject. However, the committee has had its financial services sector expertise bolstered since its initial report with the addition of Howard Wetston, former chairman of the Ontario Securities Commission, and Sabi Marwah, former vice chairman and chief operating officer at Bank of Nova Scotia.

The Senate committee began questioning federal Finance Minister Bill Morneau in late September about the current condition of the cryptoassets market and its evolution in the three years since the committee issued its recommendations as part of its overall mandate to review the state of the financial services system.

During that hearing, Morneau said that because the cryptoasset phenomenon is global in nature, the policy response must be co-ordinated at the global level: “The world’s financial systems are highly integrated and it’s easy for sophisticated users of cryptoassets to adapt their practices – for initial coin offerings or subsequent exchanges – to avoid regulation.”

However, a report from the Financial Stability Board (FSB), a global umbrella group for fi- nancial services sector policy- makers, concluded in July that at this point, the cryptoassets market is too small to represent any systemic risk to the global financial services system.

According to the BoC’s report, the total worldwide market value of all cryptoassets peaked at more than $1 trillion at the beginning of 2018. In contrast, the market capitalization of global equities markets was more than $75 trillion. Notably, the market value of cryptoassets has fallen substantially since that peak.

Given the FSB’s report’s conclusion, Morneau noted, most countries (including Canada) still are taking a restrained approach to regulation. They remain wary of suppressing innovation by cracking down too hard on the industry, but also now are beginning to erect defences due to long-standing concerns about tax evasion and money laundering.

Indeed, Morneau indicated that money laundering has emerged as the central concern for global policy-makers in regard to cryptoassets.

“We have had this discussion literally every time the G7 finance ministers and central bank governors get together,” Morneau told the Senate committee. “The focus has been on trying to find ways we can work together because this is an area [in which] we have no choice but to work together.”

Later this month, the global intergovernmental Financial Action Task Force on Money Laundering (FATF) is expected to issue guidance that would establish how its regulatory standards for fighting money laundering and terrorist financing should be applied in the cryptoassets industry.

“This is a significant step forward,” Morneau said, noting that this step will mean the FATF is going beyond simply monitoring the issues, and taking action.

Over the summer, the Department of Finance Canada launched a consultation on proposed changes to Canada’s anti-money laundering (AML) rules that aim to capture dealers of cryptoassets and virtual currencies under the existing framework for monitoring financial transactions in Canada.

When those changes take effect, financial services firms will be required to register with the Financial Transactions and Reports Analysis Centre of Canada (FINTRAC) and develop compliance strategies for detecting and reporting suspicious transactions.

At the same time, the revised AML regulations aim to define “cryptoassets” and draw a line between these investment instruments and traditional currencies.

“This approach will improve regulatory certainty surrounding cryptoassets without regulating the underlying technology, in keeping with our goal of mitigating risk without stifling innovation,” Morneau said.

Yet, the Senate committee questioned if extending FINTRAC rules to the cryptoassets space is enough. Marwah noted that cryptoassets are designed to evade regulation. He also wonders whether simply applying the AML requirements from the traditional financial system to the emerging cryptoassets markets is adequate. He questioned whether Canada should require that cryptoassets be traded on securities exchanges, where those investment instruments can be more easily monitored.

During the Senate hearing, Rob Stewart, associate deputy minister of finance and G7/G20 deputy for Canada, indicated that there are ongoing discussions among Finance Canada, the BoC and the provincial securities regulators about tracking cryptoasset trading activity.

“At this point, the judgment has not been that we need to, collectively or at an individual level, tighten the rules further than we have currently proposed to do in the AML rules,” Stewart said.

Wetston told the hearing that there appears to be an appetite for regulation among firms establishing the cryptoassets market: “My discussion with some of the digital currency firms suggests they want a framework. They want to function in a legitimate environment.”

Wetston also noted the global financial crisis highlighted the risks in allowing certain financial activities to grow unchecked: “I implore you to think about our experiences in the past and avoid the delay that’s necessary to put this framework in place [to] ensure these businesses can function on a platform and have the regulatory audit, tracking, tracing and transparency necessary.”

Stewart believes the cryptoassets market is receiving “greater scrutiny” as a result of the financial crisis. But, he said, the industry is not considered significant enough to warrant a major effort to regulate the space tightly: “The judgment call at this point in time is that the scale of the activity at a market level has not come anywhere near the scale of the activity of derivatives or asset-backed commercial paper.”

Thus, policy-makers aren’t yet prepared to impose an overarching regulatory framework on the cryptoassets industry.

“We are enhancing consumer protections and disclosure,” Stewart noted, adding that securities regulators are focusing on investor protection and federal authorities are targeting the money laundering concern.

The Standing Senate Committee on Banking, Trade and Commerce plans to study the concept of “open banking,” which is an approach to enhancing competition in the financial services sector that the federal government also is set to explore.

In the most recent federal budget, the government announced that it planned to examine the idea of open banking. This concept would enable bank customers to share their financial data with third-party firms, such as fintech firms, so that the data can be used to develop more innovative products and services.

In late September, federal Finance Minister Bill Morneau announced the launch of an advisory committee to review the idea. A consultation paper will be published later this year to guide the work of the committee, which is composed of Colleen Johnston, Toronto-Dominion Bank’s former chief financial officer; Ilse Treurnicht, former CEO of the MaRS Discovery District; Kirsten Thompson, partner and national lead, transformative technologies and data strategy, with Dentons Canada LLP; and François Lafortune, founder and CEO of Diagram, a Montreal-based fintech incubator.

The advisory committee will produce a report that assesses the potential merits of open banking in Canada. At the same time, the Senate committee has undertaken its own study of the benefits and challenges posed by open banking, focusing on the federal government’s regulatory role.

Although the government has signalled its interest in the potential benefits of embracing open banking, concerns have been cited about risks to customers’ privacy, security and overall financial stability.

The launch of the federal advisory committee and the Senate committee’s pending review come as the federal Competition Bureau continues to push policy-makers to encourage fintech innovation. In late September, the bureau published a progress report following up on the bureau’s fintech market study, the report for which was released last December and called on regulators and policy-makers to advance the cause of innovation in the financial services sector.

The Competition Bureau’s report stated that although Canada is making strides, “there is more work to be done.” In particular, the report noted, the bureau will be scrutinizing “the government’s commitment to examine open banking and modernize the financial sector framework.”